Section 530 and IRS Employment Tax Audits: Worker Classification and Relief
Worker Classification and Section 530 Relief
Employers are required to pay employment taxes to the IRS. Generally, these payments consist of two portions: the employee’s portion of FICA and income taxes and the employer’s portion of FICA and unemployment (FUTA) taxes. Employers who fail to timely remit employment taxes to the IRS run the risk of being held liable for not only the employment taxes, but also penalties and interest for late payment.
But independent contractors are treated differently than employees. Specifically, if a worker is properly characterized as an independent contractor (as opposed to an employee), the taxpayer making payment to the independent contractor is not required to remit payment to the IRS. Rather, the independent contractor—particularly in the case of an individual sole proprietorship—pays self-employment taxes on the business’s net income.
Because of the distinction, taxpayers generally prefer to treat their workers as independent contractors. Conversely, the workers prefer employee treatment. In most instances, the tie will go the taxpayer-payor, though, because the payor has more leverage over the characterization of the worker as an independent contractor or employee. That is, at least via contract.
Of course, the IRS is well aware of taxpayers’ general inclinations to treat their workers as independent contractors. Congress is too. Accordingly, under federal tax law, the IRS has the authority to recharacterize workers as employees, even if the two agree that they should be treated as independent contractors.
Taxpayers in these situations are not without defenses. Although there are many, a common defense that may be raised is Section 530 relief. To the extent a taxpayer can convince the IRS Section 530 relief applies, the taxpayer can avoid costly employment taxes. Moreover, the taxpayer can continue to treat their workers as independent contractors. A brief summary of Section 530 relief is discussed below.
Common Law Factors (Employee v. Independent Contractor).
Prior to getting into Section 530 relief, it is important to understand the difference between an employee and an independent contractor. Under federal tax law, the term “employee” is defined to include “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status as an employee.”[i] The common law test looks at a multitude of factors—none necessarily determinative—as a means to analyze the relationship between the taxpayer and the worker.
The governing regulations provide additional color on the characterization of a worker as an employee or independent contractor. Under those regulations, the primary factor in determining whether a worker is an employee or an independent contractor is the extent of control the payor has over the work performed.[ii] However, federal tax law also look at other factors, such as: (1) which party invests in the facilities used in the work; (2) the opportunity of the worker to make a profit or loss; (3) whether or not the principal has the right to discharge the individual; (4) whether the work is part of the principal’s regular business; (5) the permanency of the relationship; and (6) the relationship the parties believe they are creating.[iii]
Section 530 Relief.
Since 1978, Congress has provided so-called Section 530 relief to taxpayers who meet all of its requirements.[iv] These requirements include: (1) the consistency requirement; (2) the historic treatment requirement; and (3) the reasonable basis requirement. Each of these requirements is discussed in turn below.
Reporting Consistency Requirement.
The reporting consistency requirement looks at whether the taxpayer has consistently reported the worker as an independent contractor. Accordingly, the IRS looks at whether the taxpayer has issued Forms 1099 each year to the worker or group of workers.[v] Although some courts have disagreed, the IRS also contends that the Forms 1099 must have been filed timely to satisfy this requirement.
Historic Treatment Requirement.
Under the historic treatment requirement, the taxpayer must not have treated an individual (or individuals in substantially similar roles) as an employee for any period beginning after December 31, 1977. To the extent the taxpayer has treated certain workers as employees, Section 530 relief does not apply.
Reasonable Basis Requirement.
In many cases, taxpayers can sufficiently show compliance with the reporting consistency and historic treatment requirements. However, the third requirement—the catch-all reasonable basis requirement—tends to be a more difficult sell for taxpayers to make to the IRS. The safe harbors and the catch-all reasonable basis standard are discussed below.
Safe Harbors and Other Reasonable Basis Standard.
The legislative history of Section 530 provides taxpayers with some help in satisfying their burden of proof in showing reasonable basis. Specifically, that legislative history indicates that the reasonable basis requirement should be construed “liberally” in favor of taxpayers.[vi] Although the standard is a helpful one, the taxpayer still has the initial burden to show relief. Moreover, taxpayers should be cautious that under many of the reasonable basis standards, the IRS and federal courts will not permit taxpayers to use “after-the-fact” reliance arguments.[vii] That is, in some instances, the taxpayer must show that they were aware of and relied upon the factors prior to making a determination to treat the workers at issue as independent contractors.
Judicial Precedent, Published Rulings, Technical Advice, or a Letter Ruling.
The first safe harbor is reliance on certain federal tax authority. A taxpayer meets this requirement if the taxpayer can show reliance on judicial decisions and/or IRS published rulings, provided the facts in those tax authorities are substantially the same as the facts under audit.[viii] A taxpayer also meets this safe harbor requirement if the taxpayer received technical advice or a letter ruling from the IRS regarding the worker determination.[ix]
Prior IRS Audit.
The second safe harbor applies if the taxpayer can show: (1) the IRS previously audited the taxpayer; (2) the IRS determined in that prior audit that the taxpayer’s workers were independent contractors; (3) the workers subject to the prior audit were substantially similar to the workers at issue; and (4) the taxpayer treated the two groups of workers in a substantially similar fashion.[x] Generally, an audit occurs when the IRS, at a minimum, looks at the taxpayer’s books and records.[xi]
Long-Standing Industry Practice.
The third safe harbor applies if the taxpayer can show a long-standing industry practice. More specifically, the taxpayer must show that: (1) a long-standing recognized industry practice exists in a significant segment of the industry; and (2) the taxpayer reasonably relied on this practice in the tax treatment of its workers.[xii] For these purposes, a significant segment does not mean a majority—rather, “one or two businesses may constitute a significant segment of an industry.”[xiii] A number of taxpayer-friendly rules apply under this safe harbor, particularly because the evidentiary burden on the taxpayer is perhaps the greatest under this safe harbor.
“Catch-All” Reasonable Basis.
In many instances, a taxpayer will not fall under any of the safe harbors. If this occurs, the taxpayer will need to persuade the IRS that the catch-all reasonable basis standard applies. Although this standard considers almost any relevant factor, it is often the most difficult of the standards to have the IRS agree upon.[xiv] Accordingly, taxpayers who intend to rely on this factor should ensure that they properly set forth their arguments and supporting facts to the IRS.
Relief from Improperly Classifying Workers.
Used appropriately, Section 530 relief is a powerful taxpayer-friendly rule in disputed worker classification issues with the IRS. However, Section 530 is not an easy statute to understand. Aside from the above matters, which have only been discussed briefly, Section 530 contains a litany of other complex procedural matters, including proper timing to raise the defense, proper presentment of evidence, and certain burden-shifting mechanisms. To the extent the taxpayer properly utilizes Section 530, though, the taxpayer can substantially reduce its exposure to several years of employment taxes and subsequent treatment of workers as employees.
[i] 26 U.S.C. § 3121(d)(2).
[ii] See Treas. Reg. §§ 31.3121(d)(1) (FICA); 31.3306(i)-1 (FUTA); see also Peno Trucking, Inc. v. Comm’r, 296 Fed. Appx. 449 (6th Cir. 2008).
[iii] Peno Trucking, Inc., 296 Fed. Appx. At 456, and cases cited therein.
[iv] Revenue Act of 1978, Pub. L. No. 95-600.
[v] See, e.g., CCA 200948043 (noting that issuing a Form W-2 to a worker would be inconsistent with claiming the worker as an independent contractor).
[vi] See H.R. Rep. No. 1748, 95th Cong., 2d Sess. 5, 1978-3 C.B. (Vol. 1) 629, 633.
[vii] See, e.g., 303 West 42nd St. Enters. v. IRS, 181 F.3d 272, 277 (2d Cir. 1999 (focusing analysis on whether the taxpayer “in fact relied on” the grounds alleged); Nu-Look Design Inc. v. Comm’r, 85 T.C.M. (CCH) 927 (2003) (“The statute does not countenance ex post facto justification.”); Veterinary Surgical Consultants, P.C. v. Comm’r, 85 T.C.M. (CCH) 901 (2003) (courts must apply Section 530 relief when “the taxpayer . . . relied on the alleged authority . . . at the time the employment decisions were being made.”).
[viii] See CCA 200948043 (“As to judicial precedent or published rulings, the Service will look to whether the facts of the judicial precedent or published rulings are sufficiently similar to the taxpayer’s facts.”).
[ix] See CCA 200948043 (noting that PLR and TAM do not provide a safe harbor to the taxpayer in question because those were issued to other taxpayers).
[x] See Smokey Mountain Secrets, Inc. v. U.S., 910 F. Supp. 1316, 1325 (E.D. Tenn. 1995) (citing Lambert’s Nursery and Landscaping, Inc. v. U.S., 894 F.2d 154, 156 (5th Cir. 1990).
[xi] Conference Report, H.R. Rep. No. 104-737, 104th Cong., 2d Sess., at 200 (1996).
[xii] Texture Source, Inc. v. U.S., 851 F. Supp. 2d 1260, 1265 (D. Nev. 2012).
[xiii] Hospital Resource Personnel, Inc. v. U.S., 68 F.3d 421, 427 (11th Cir. 1995).
[xiv] See, e.g., Nelly Home Care, Inc. v. United States Nelly, LLC, 185 F. Supp.3d 653 (E.D. Penn. 2016); see also H. Rep. No. 1748, 95th Cong., 2d Sess. 5, reprinted in 1978-3 C.B. 629, 632-33 (noting that Section 530 was intended to “grant[ ] relief if a taxpayer had any reasonable basis for treating workers as other than employees.”); CCA 200948043 (“A taxpayer who fails to meet any of the three safe harbors may nevertheless be entitled to relief if the taxpayer can demonstrate, in some manner, a reasonable basis for not treating the individual as an employee.”).